ReAble Therapeutics 10Q 2006 Q1 Quarterly report

FORM 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended April 1, 2006


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 0-26538

ENCORE MEDICAL CORPORATION

(Exact name of Registrant as specified in its charter)


Delaware		65-0572565
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

9800 Metric Boulevard
Austin, Texas		78758
(Address of principal executive offices)		(Zip code)

512-832-9500
(Registrant’s telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesþ Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in
Rule 12b-2 of the Exchange Act).


Large accelerated filero		Accelerated filerþ		Non-accelerated filero

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yeso Noþ

The number of shares outstanding of each of the issuer’s classes of common stock as of the close of business on May 1, 2006:


Class		Outstanding as of May 1, 2006

Common Stock; $0.001 Par Value per Share		71,004,134 shares

ENCORE MEDICAL CORPORATION

Quarterly Report on Form 10-Q
For the period ended April 1, 2006

TABLE OF CONTENTS


	Page
PART I.

Item 1. Financial Statements		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		22
Item 3. Quantitative and Qualitative Disclosures About Market Risk		30
Item 4. Controls and Procedures		31

PART II.

Item 1. Legal Proceedings		31
Item 1A. Risk Factors		31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		32
Item 3. Defaults Upon Senior Securities		32
Item 4. Submission of Matters to a Vote of Security Holders		32
Item 5. Other Information		32
Item 6. Exhibits		32
Signatures		33
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification of CEO Pursuant to Section 906
Certification of CFO Pursuant to Section 906

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Part I. Financial Information

Item 1. Financial Statements

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets
As of April 1, 2006 and December 31, 2005
(in thousands, except share and per share data)
(unaudited)


	April 1,			December 31,
	2006			2005
Assets
Current assets:
Cash and cash equivalents	$	22,927		$	17,200
Accounts receivable, net		102,648			53,809
Inventories, net		73,379			56,433
Deferred tax assets		15,262			9,538
Prepaid expenses and other current assets		5,849			4,613
Assets of discontinued operations		7			14


Total current assets		220,072			141,607

Property and equipment, net		35,005			26,742
Goodwill		327,866			290,255
Intangible assets, net		108,884			82,378
Deferred tax assets		1,889			—
Other assets		10,753			11,055


Total assets	$	704,469		$	552,037


Liabilities, Minority Interests and Stockholders’ Equity
Current liabilities:
Current portion of long-term debt and capital leases	$	9,845		$	7,287
Accounts payable		17,687			11,820
Accrued expenses		34,400			26,941
Liabilities of discontinued operations		92			295


Total current liabilities		62,024			46,343
Long-term debt and capital leases , net of current portion		331,701			307,794
Deferred tax liabilities		40,597			29,663
Other non-current liabilities		474			460


Total liabilities		434,796			384,260

Minority interests		747			670

Stockholders’ equity:
Common stock, $0.001 par value, 100,000,000 shares authorized; 71,516,000 and 52,365,000 shares issued, respectively		72			52
Additional paid-in capital		258,345			155,399
Notes received for sale of common stock		(846	)		(846	)
Retained earnings		13,381			15,906
Accumulated other comprehensive loss		(376	)		(1,757	)
Less cost of repurchased stock (512,000 shares)		(1,650	)		(1,647	)


Total stockholders’ equity		268,926			167,107


Total liabilities, minority interests and stockholders’ equity	$	704,469		$	552,037

See accompanying notes to unaudited consolidated financial statements.

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
For the three months ended April 1, 2006 and April 2, 2005
(in thousands, except per share amounts)
(unaudited)


	Three Months Ended
	April 1,			April 2,
	2006			2005
Net sales	$	88,125		$	71,559
Cost of sales		35,707			29,031

Gross margin		52,418			42,528

Operating expenses:
Selling, general and administrative		39,242			30,979
Research and development		6,848			2,479


Operating income		6,328			9,070

Other income (expense):
Interest income		121			84
Interest expense		(7,518	)		(6,997	)
Other income (expense), net		(116	)		24


Income (loss) from continuing operations before income taxes and minority interests		(1,185	)		2,181

Provision for income taxes		1,279			873

Minority interests		59			26


Income (loss) from continuing operations		(2,523	)		1,282

Discontinued operations:
Income (loss) from discontinued operations (net of income tax (benefit) expense of $(2) and $207, respectively)		(2	)		311

Net income (loss)	$	(2,525	)	$	1,593


Earnings (loss) per share — basic:
Income (loss) from continuing operations	$	(0.04	)	$	0.02
Income (loss) from discontinued operations		—			0.01

Net income (loss)	$	(0.04	)	$	0.03


Earnings (loss) per share — diluted:
Income (loss) from continuing operations	$	(0.04	)	$	0.02
Income (loss) from discontinued operations		—			0.01

Net income (loss)	$	(0.04	)	$	0.03


Weighted average number of common shares outstanding:
Basic		58,982			51,700
Diluted		58,982			52,432

See accompanying notes to unaudited consolidated financial statements.

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flow
For the three months ended April 1, 2006 and April 2, 2005
(in thousands)
(unaudited)


	Three Months Ended
	April 1,			April 2,
	2006			2005
OPERATING ACTIVITIES:
Net income (loss)	$	(2,525	)	$	1,593
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation		2,334			2,043
Amortization of intangibles		1,466			1,210
Amortization of debt issuance costs		542			553
Non-cash interest expense		27			24
Stock-based compensation		823			38
Loss on disposal of assets		222			207
Deferred income taxes		(74	)		2,646
Provision for bad debt expense and sales returns		2,079			1,132
Inventory reserves		1,064			1,484
Minority interests		59			26
Excess tax benefit associated with stock option exercises		(945	)		(49	)
In-process research and development		4,016			—
Net effect of discontinued operations		(196	)		88
Changes in operating assets and liabilities, net of acquired assets and liabilities:
Accounts receivable		(5,465	)		2,852
Inventories		(2,217	)		(4,640	)
Prepaid expenses, other assets and liabilities		183			(2,266	)
Accounts payable and accrued expenses		(879	)		(7,295	)

Net cash provided by (used in) operating activities		514			(354	)
INVESTING ACTIVITIES:
Acquisition of businesses, net of cash acquired		(235	)		(15,246	)
Proceeds on sale of assets		61			—
Purchases of property and equipment		(3,833	)		(2,048	)
Acquisition of intangibles		(384	)		—
Net effect of discontinued operations		—			(2	)

Net cash used in investing activities		(4,391	)		(17,296	)
FINANCING ACTIVITIES:
Proceeds from issuance of common stock		2,416			48
Proceeds from notes received for sale of common stock		—			102
Excess tax benefit associated with stock option exercises		945			—
Proceeds from long-term obligations		25,300			14,700
Payments on long-term obligations		(19,141	)		(2,126	)
Payment of debt issuance costs		—			(166	)
Dividend paid to minority interests		—			(198	)

Net cash provided by financing activities		9,520			12,360
Effect of exchange rate on cash and cash equivalents		84			(287	)

Net increase (decrease) in cash and cash equivalents		5,727			(5,577	)
Cash and cash equivalents at beginning of year		17,200			19,889

Cash and cash equivalents at end of period	$	22,927		$	14,312

Supplemental disclosures of cash flow information:
Cash paid for interest	$	2,795		$	10,278
Cash paid for income taxes		571			1,148
Non-cash investing and financing activities:
Capital lease obligations related to equipment leases	$	384		$	—

See accompanying notes to unaudited consolidated financial statements.

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements
(Unaudited)

1. BASIS OF PRESENTATION AND DESCRIPTION OF BUSINESS

Basis of Presentation

The accompanying consolidated financial statements include the accounts of Encore Medical Corporation, a Delaware corporation, and its wholly owned subsidiaries and those entities in which we hold a controlling interest (individually and collectively referred to as “us,” “we,” “our company” or “Encore”). Minority interest reflects the 50% separate ownership of Medireha GmbH (“Medireha”) due to our controlling interest which results from our being Medireha’s only customer and our ability to direct Medireha’s production and research and development efforts. All significant intercompany balances and transactions have been eliminated in consolidation. The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The consolidated financial statements and accompanying footnotes reflect certain reclassifications that have been made to prior period information to conform to the current year presentation. These reclassifications have no effect on previously reported net income (loss). Operating results for the three-month period ended April 1, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in our Form 10-K dated December 31, 2005.

Description of Business

We are a diversified orthopedic device company that develops, manufactures and distributes a comprehensive range of high quality orthopedic devices, including sports medicine equipment and products for orthopedic rehabilitation, pain management and physical therapy, and surgical implants. Our products are used by orthopedic surgeons, physicians, therapists, athletic trainers and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries, and a substantial amount of our non-invasive medical devices and related accessories are primarily used by patients for at-home physical therapy.

We currently market and distribute our products through two operating divisions, our Orthopedic Rehabilitation Division and our Surgical Implant Division. Our Orthopedic Rehabilitation Division offers non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables and traction equipment; and orthotics devices used to treat joint and spine conditions. Our Surgical Implant Division offers a comprehensive suite of reconstructive joint products and spinal implants.

Our products are subject to regulation by the Food and Drug Administration (“FDA”) with respect to their sale in the United States, and we must, in many cases, obtain FDA authorization to market our products before they can be sold in the United States. Additionally, we are subject to similar regulations in many of the foreign countries in which we sell products.

Stock Based Compensation

Change in Accounting Principle

Effective January 1, 2006, we adopted the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123(R) “Share-Based Payment” (“SFAS 123R”) using the modified prospective method, in which compensation cost was recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123R for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date.

As permitted under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), we elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations in accounting for stock-based awards to employees prior to January 1, 2006. Accordingly, compensation cost for stock options was measured as the excess, if any, of the market price of our common stock at the date of grant over the exercise price. Historically, we had not recognized any compensation cost under APB 25.

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Prior to the adoption of SFAS 123R, we presented the tax savings resulting from tax deductions resulting from the exercise of stock options as an operating cash flow, in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123R requires us to reflect the tax savings resulting from tax deductions in excess of expense reflected in its financial statements as a financing cash flow.

In November 2005, the FASB issued Staff Position No. FAS 123R-3, “Transition Election Related to Accounting for the Tax Effects of the Share-Based Payment Awards” (“FSP FAS 123R-3”). We have elected to adopt the transition guidance for the additional paid-in-capital pool (“APIC pool”) in paragraph 81 of SFAS 123R. The prescribed transition method is a detailed method to establish the beginning balance of the APIC pool related to the tax effects of share-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statement of Cash Flows of the tax effects of share-based compensation awards that are outstanding upon adoption of SFAS 123R.

With the adoption of SFAS 123R, we elected to amortize stock-based compensation for awards granted on or after the adoption of SFAS 123R on January 1, 2006 on a straight-line basis over the requisite service (vesting) period for the entire award.

Summary of Plans

As of April 1, 2006, up to 10,361,969 shares of common stock are authorized to issue in connection with our Stock Plans to directors, employees and consultants. Under our Stock Plans, options generally expire ten years from the date of grant. Vesting periods are determined by the Board of Directors and generally provide for shares to vest ratably over a period of three years.

The 1996 Incentive Stock Plan (the “96 Plan”) provides for the grant of a variety of equity related awards, including, but not limited to, incentive stock options, non-qualified stock options, stock appreciation rights and restricted stock, to key employees of Encore and its subsidiaries. On February 23, 2006, our stockholders approved an amendment to our 96 Plan increasing the number of shares of common stock authorized for issuance under the 96 Plan from 4,500,000 to 9,500,000. The 1997 Distributor Advisory Panel Stock Option Plan provides for the grant of stock options to those persons or entities that are our sales representatives and distributors of our products. The 1997 Surgeon Advisory Panel Stock Option Plan provides for the grant of stock options to those surgeons who are serving as members of our surgeon advisory panel. The 2000 Non-Employee Director Stock Option Plan provides for the grant of options to non-employee directors of Encore. The Empi individual option agreement plan includes incentive stock options and non-qualified stock options available for grant to employees of Empi, who joined our company as a result of the acquisition of Empi.

Summary of Assumptions and Activity

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model that uses the assumptions noted in the following table. Expected volatilities are based on the historical volatility of our common stock, and other factors such as implied volatility of traded options. The expected life assumptions were derived from our review of annual historical employee exercise behavior of option grants with similar vesting periods. Expected life is calculated in two tranches based on the employment level in the company defined as management or non-management. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and experience.


	Three Months Ended
	April 1,			April 2,
	2006			2005*
Dividend yield		0.0	%		0.0	%
Expected volatility		61.03	%		81.7	%
Risk-free interest rate		4.5	%		4.1	%
Expected life		4.5 to 5.6 years		4.1 years


*		The assumptions used in the three months ended April 2, 2005 were used to calculate pro forma compensation expense per SFAS 123.

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A summary of option activity as of April 1, 2006, and changes during the quarter then ended, is presented below:


				Weighted		Weighted Average
				Average		Remaining Contractual		Aggregate
	Shares			Exercise Price		Term (Years)		Intrinsic Value
Outstanding, beginning of year		4,018,305		$	5.02
Granted		4,064,582			4.01
Exercised		(890,405	)		2.72
Canceled		(16,075	)		7.76

Outstanding, end of period		7,176,407		$	4.73		8.59	$	6,050,822

Options exercisable at period end		3,861,590		$	4.54		8.00	$	5,069,292

The weighted average grant date fair value of options granted during the quarter ended April 1, 2006 was $3.80 per option. The total intrinsic value of options exercised during the quarter ended April 1, 2006 was $2.7 million. Upon the exercise of options, we issue new common stock from our authorized shares.

Total unrecognized stock-based compensation expense related to nonvested stock options was approximately $8.1 million as of April 1, 2006. We anticipate this expense to be recognized over a weighted average period of approximately two years.

The following table summarizes the effect of adopting SFAS 123R for the quarter ending April 1, 2006:


Stock-option compensation expense recognized:
Cost of sales	$	16
Selling, general and administrative		794
Research and development		8


Total	$	818
Related deferred income tax benefit		110

Decrease in net income	$	708


Impact on basic and diluted net loss per common share	($	0.01	)

Pro-Forma Disclosure for Quarter ended April 1, 2005

If the fair value based method prescribed by SFAS 123 had been applied in measuring employee stock compensation expense for the three months ended April 1, 2005, the pro-forma effect on net income and net income per share would have been as follows (in thousands, except per share amounts):


		Three Months Ended
		April 1, 2005
Net income	As reported	$	1,593

Deduct: Total stock-based compensation expense determined under fair value-based method for all awards, net of related tax effects			(269	)

Net income	Pro forma	$	1,324


Earnings per share:
Basic:	As reported	$	0.03
	Pro forma	$	0.03
Diluted:	As reported	$	0.03
	Pro forma	$	0.03

The weighted average grant date fair value of options granted during the quarter ended April 2, 2005 was $3.35 per option.

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2. ACCOUNTS RECEIVABLE

A summary of activity in our accounts receivable reserves for doubtful accounts and sales returns is presented below (in thousands):


	April 1,			April 2,
	2006			2005
Balance, beginning of year	$	4,016		$	2,735
Provision		2,079			1,132
Write-off charges and recoveries		(2,377	)		15

Balance, end of period	$	3,718		$	3,882

3. INVENTORIES

Inventories consist of the following (in thousands):


	April 1,			December 31,
	2006			2005
Components and raw materials	$	18,279		$	13,697
Work in process		6,502			5,516
Finished goods		37,590			30,314
Inventory held on consignment		18,487			14,303

		80,858			63,830
Less-inventory reserves		(7,479	)		(7,397	)

	$	73,379		$	56,433

A summary of the activity in our inventory reserve for slow moving, excess, product obsolescence and valuation is presented below (in thousands):


	April 1,			April 2,
	2006			2005
Balance, beginning of year	$	7,397		$	4,993
Provision charged to cost of sales		1,064			1,484
Write-offs charged to reserve		(982	)		(361	)

Balance, end of period	$	7,479		$	6,116

The write-offs to the reserve were principally related to the disposition of fully reserved inventory.

4. GOODWILL AND INTANGIBLE ASSETS

A summary of the activity in goodwill is presented below (in thousands):


	April 1,
	2006			December 31, 2005
Balance, beginning of year	$	290,255		$	286,231

Adjustment related to resolution of contingencies		—			5,958

Goodwill associated with the acquisition of Osteoimplant Technology, Inc. (“OTI”)		474			6,360

Goodwill associated with the acquisition of Compex Technologies, Inc. (“Compex”)		36,729			—
Adjustment related to tax benefit associated with Compex stock option exercises		(912	)		—

Foreign currency translation		1,320			(8,294	)

Balance, end of period	$	327,866		$	290,255

During 2005, the purchase price we paid to acquire Empi, Inc. (“Empi”) was adjusted to reflect the resolution of two contingencies. The first contingency related to an anticipated closing tax benefit generated by the completion of our Empi acquisition, which resulted in a $6.0 million payment to Empi’s former stockholders and option holders. The second

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contingency related to completion of the audit of Empi’s closing date balance sheet that resulted in a return to us of $291,000 of the original acquisition consideration. In addition, we incurred an additional $249,000 in purchase costs.

Refer to notes 9 and 10 for a discussion of the OTI and Compex acquisitions, respectively.

At April 1, 2006, we have goodwill and intangible assets as follows (in thousands):


	Goodwill		Intangibles, net
Orthopedic Rehabilitation Division	$	317,610	$	105,243
Surgical Implant Division		10,256		3,641

Total	$	327,866	$	108,884

Intangibles consisted of the following as of April 1, 2006 (in thousands):


	Gross Carrying		Accumulated			Intangibles,
	Amount		Amortization			Net
Amortizable intangible assets:
Technology-based	$	19,326	$	(2,743	)	$	16,583
Customer-based		61,252		(5,960	)		55,292

	$	80,578	$	(8,703	)		71,875

Unamortizable intangible assets:
Trademarks							37,348
Foreign currency translation							(339	)

Total intangible assets						$	108,884

Intangibles consisted of the following as of December 31, 2005 (in thousands):


	Gross Carrying		Accumulated			Intangibles,
	Amount		Amortization			Net
Amortizable intangible assets:
Technology-based	$	10,552	$	(2,281	)	$	8,271
Customer-based		48,011		(4,956	)		43,055

	$	58,563	$	(7,237	)		51,326

Unamortizable intangible assets:
Trademarks							31,768
Foreign currency translation							(716	)

Total intangible assets						$	82,378

During the three months ended April 1, 2006, we acquired $27.2 million of intangible assets in connection with the Compex acquisition and $384,000 of other intangible assets. Amortization expense for the three months ended April 1, 2006 and April 2, 2005 were $1,466,000 and $1,210,000, respectively.

Our amortizable assets will continue to be amortized over their useful lives ranging from 2 to 20 years.

Our estimated amortization expense for the nine months ended December 31, 2006 and the next five years is as follows (in thousands):


For nine months ended December 31, 2006	$	5,519
For year ended December 31, 2007		7,046
For year ended December 31, 2008		6,755
For year ended December 31, 2009		6,477
For year ended December 31, 2010		5,800
For year ended December 31, 2011		5,614

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5. LONG-TERM DEBT

Long-term debt (including capital lease obligations) consists of the following (in thousands):


	April 1, 2006			December 31, 2005
$200 million senior credit facility to a syndicate of financial institutions; composed of a $150 million six-year term loan and a five-year $50 million revolving credit facility due October 2010; collateralized by all domestic assets of Encore and pledge of 66% of the stock of foreign subsidiaries of Encore; interest rate at Bank of America’s base rate or the London Interbank Offered Rate (LIBOR), plus an applicable margin determined by, among other things, the ratio of total debt to earnings before interest, taxes, depreciation and amortization (EBITDA); $10 million available under the revolving credit facility as of April 1, 2006; term loan subject to quarterly principal installments of (a) $1.8 million each of the next 7 quarters, (b) $3.6 million each of the following 8 quarters, and (c) $23.2 million each of the last 4 quarters with the last payment due October 2010; interest rate of 7.34% and 7.22% at April 1, 2006 and December 31, 2005, respectively.	$	173,757		$	150,241
$165 million senior subordinated notes payable to institutional investors issued at 99.314% of principal amount; less unamortized discount of $981 and $1,008 at April 1, 2006 and December 31, 2005, respectively; interest rate of 9.75%; interest payable semi-annually on April 1 and October 1 of each year through October 1, 2012; junior and subordinate to senior credit facility; prepayable at a premium commencing October 1, 2008.		164,019			163,992
$5 million Swiss credit facility that provides for a three-year term loan at varying rates; collateralized by the equity interest held by Compex’s Swiss subsidiary in Filsport; payable on June 30, 2006, interest rate of 4.40% at April 1, 2006.		2,427			—
Note payable to a corporation, which is principally owned by an employee of the Company, in connection with the acquisition of Rehab Med+Equip by Empi in 2002; payable in July 2008; interest rate at higher of 5% or prime on the first business day of each calendar quarter; interest rate of 7.25% and 6.75% at April 1, 2006 and December 31, 2005, respectively.		469			469
European bank loans to finance European working capital; monthly payments through March 2006, variable interest rate of 5.25% at December 31, 2005.		—			10
Capital lease obligations, collateralized by related equipment.		874			369

		341,546			315,081
Less — current portion		(9,845	)		(7,287	)

	$	331,701		$	307,794

In connection with our Compex acquisition, we incurred approximately $15.3 million in debt under our revolving credit facility, which was primarily used to repay bank debt owed by Compex. In addition, the maximum amount we can borrow under our revolving line of credit was increased from $30 million to $50 million.

The debt agreements related to the $200 million senior credit facility and the $165 million senior subordinated notes payable contain warranties and covenants and require maintenance of certain financial ratios. Default on any warranty or covenant could affect the ability to borrow under the agreements and, if not waived or corrected, could accelerate the maturity of any borrowings outstanding under both of the applicable agreements. As of April 1, 2006, we are in compliance with all debt covenants and warranties. In addition, these debt agreements restrict our ability to (i) incur additional indebtedness; (ii) issue redeemable equity interests and preferred equity interests; (iii) pay dividends or make distributions, repurchase equity interests or make other restricted payments; (iv) make capital expenditures; (v) create liens; (vi) enter into transactions with our affiliates; (vii) make investments; (viii) sell assets; or (ix) enter into mergers or consolidations.

6. SEGMENT AND GEOGRAPHIC INFORMATION

We have two reportable segments as defined by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”. Our reportable segments are business units that offer different products that are managed separately because each business requires different manufacturing and marketing strategies. The Orthopedic Rehabilitation Division offers non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables and traction equipment; and orthotics devices used to treat joint and spine conditions. Since February 24, 2006, Compex results have been included in the results of our Orthopedic Rehabilitation Division. The Surgical Implant Division sells reconstructive products including knee, hip, shoulder and spinal implants.

- 11 -

Information regarding business segments is as follows (in thousands):


	Three Months Ended
	April 1,		April 2,
	2006		2005
Net sales:
Orthopedic Rehabilitation Division	$	72,700	$	59,268
Surgical Implant Division		15,425		12,291

Consolidated net sales	$	88,125	$	71,559


Gross margin:
Orthopedic Rehabilitation Division	$	40,627	$	32,711
Surgical Implant Division		11,791		9,817

Consolidated gross margin	$	52,418	$	42,528

We allocate resources and evaluate the performance of our segments based on gross margin and therefore have not disclosed certain other items, such as depreciation, operating income, interest and income taxes as permitted by SFAS 131.

Geographic Area

Following are our net sales by geographic area (in thousands):


	Three Months Ended
	April 1,		April 2,
	2006		2005
Net sales:
United States	$	70,012	$	55,549
Germany		7,317		9,630
Other Europe, Middle East & Africa		7,653		4,183
Asia Pacific		2,413		1,304
Other		730		893

	$	88,125	$	71,559

Following are our long-lived assets by geographic area (in thousands):


	April 1,		December 31,
	2006		2005
United States	$	404,655	$	338,053
Europe		79,742		72,377

	$	484,397	$	410,430

7. DISCONTINUED OPERATIONS

We account for our discontinued operations under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Accordingly, we classified results of operations and the related charges for discontinued operations as “Income (loss) from discontinued operations, net of income tax expense (benefit)” in the accompanying Consolidated Statements of Operations. We classified assets and liabilities of the discontinued operations on the accompanying Consolidated Balance Sheets as “Assets of discontinued operations” and “Liabilities of discontinued operations.” For comparative purposes, we restated all prior periods presented to reflect the reclassifications on a consistent basis.

On August 8, 2005, we completed the sale of our orthopedic soft goods product line to dj Orthopedics, LLC (“dj”). The assets, previously included in our Orthopedic Rehabilitation Division, that were sold under the asset purchase and sale agreement included bracing, splinting and patient safety products, for which we received a cash payment of $9.5 million. Under the terms of our current credit facility, we made a $7.1 million principal payment using the net cash proceeds from the sale to dj of the pledged assets which formerly constituted our orthopedic soft goods product line.

- 12 -

Discontinued operations are as follows (in thousands):


	Three Months Ended
	April 1,			April 2,
	2006			2005
Net sales	$	—		$	3,797
Income (loss) from operations		(4	)		632
Income (loss) before income taxes		(4	)		518
Income tax (benefit) expense		(2	)		207

Income (loss) from discontinued operations	$	(2	)	$	311

8. EARNINGS PER SHARE

Following is a reconciliation of the basic and diluted per share computations (in thousands except per share data):


	Three Months Ended
	April 1,			April 2,
	2006			2005
Income (loss) from continuing operations	$	(2,523	)	$	1,282
Income (loss) from discontinued operations		(2	)		311

Net income (loss)	$	(2,525	)	$	1,593


Shares used in computing basic earnings per share		58,982			51,700
Incremental shares from assumed conversions		—			732

Shares used in computing diluted earnings per share		58,982			52,432

Earnings (loss) per share — basic:
Income (loss) from continuing operations	$	(0.04	)	$	0.02
Income (loss) from discontinued operations		—			0.01

Net income (loss)	$	(0.04	)	$	0.03

Earnings (loss) per share — diluted:
Income (loss) from continuing operations	$	(0.04	)	$	0.02
Income (loss) from discontinued operations		—			0.01

Net income (loss)	$	(0.04	)	$	0.03

Since we incurred a net loss for the first quarter of 2006, 2,828,000 incremental shares from assumed conversions were not included in the computation of diluted earnings per share because the inclusion of such would be anti-dilutive. For the quarter ended April 2, 2005, the effect of 1,144,000 incremental shares from assumed conversions were excluded as anti-dilutive.

9. ACQUISITION OF OTI

On February 22, 2005, we acquired substantially all of the assets of OTI, which included a line of spinal implant products and several total knee and hip implant designs. The total purchase price for the OTI assets of approximately $15.7 million was comprised of approximately $14.5 million payable in cash to OTI and $1.2 million in purchase costs. We borrowed $14.7 million from our existing line of credit to finance the OTI asset acquisition. The acquisition consideration is subject to adjustment based upon the final balance sheet as of the closing date, which remains the subject of a dispute between the former OTI shareholders and us. We do not anticipate the resolution of the dispute will have a material impact on our financial position or results of operations. During the first quarter of 2006, we identified $474,000 of additional obsolete inventory related to inventory acquired with our acquisition of OTI which we recorded as an adjustment to the OTI purchase price as it did not relate to post acquisition activity.

We have included the results of OTI in our consolidated statement of operations since the date of acquisition, February 22, 2005.

10. ACQUISITION OF COMPEX

On February 24, 2006, pursuant to the terms of a merger agreement dated November 14, 2005, we acquired Compex, a Minnesota corporation. The total purchase price of approximately $102.7 million was comprised of 18.3 million shares of our common stock, valued at $90.0 million, options to purchase 2.3 million shares of our common stock valued at $9.8 million, plus $2.9 million in purchase costs. We funded the merger, which we refer to as the Compex acquisition, with our

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common stock and with $15.3 million of borrowings under the revolving credit facility with our senior creditors (see Note 5). In connection with the acquisition, we retired $17.3 million of outstanding Compex debt.

The fair value of the Encore common stock issued of $90.0 million was determined as $4.93 per share based upon the average closing price of Encore’s common stock on the Nasdaq National Market for the period from two days before to two days after the announcement of the Compex acquisition.

Under the purchase method of accounting, the total purchase price is allocated to the acquired tangible and identifiable intangible assets and the assumed liabilities of Compex based upon their estimated fair values as of the date of the merger. The following represents the preliminary allocation of the aggregate purchase price as of February 24, 2006. Fair value for certain of the assets acquired (inventory, fixed assets, intangible assets) was estimated based upon preliminary evaluations. For the remaining assets and liabilities, book value was deemed to approximate fair value due to the nature of the assets and liabilities. The following valuations are preliminary and are subject to change upon completion of independent third party appraisals and further evaluation of the assets acquired and liabilities assumed (in thousands):


Current assets	$	73,301
Tangible and other non-current assets		8,537
Liabilities assumed		(47,131	)
In-process research and development		4,016
Identifiable intangible assets		27,211
Goodwill		36,729

	$	102,663

Included in the liabilities assumed is approximately $17.3 million of Compex debt that we paid upon closing of the Compex acquisition funded in part by our borrowing under our revolving line of credit. The acquired intangible assets consist of the following, and are being amortized over their estimated economic life, where applicable, using the straight-line method (in thousands, except useful life):


Asset Class	Fair Value		Wtd. Avg. Useful Life
Technology-based	$	8,523	7 years
Customer-based		13,107	11 years
Trademarks		5,581	Indefinite
In-process research and development		4,016
Goodwill		36,729

	$	67,956

Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and liabilities assumed, and is not tax deductible.

We are currently evaluating our plans with respect to the acquired Compex operations and the integration of such into the Company. The completion of this evaluation could result in adjustments to the purchase price allocation. The results of Compex have been included within the consolidated statement of operations since the date of acquisition, February 24, 2006.

The following pro forma information presents results of operations of Encore as if the acquisition of Compex occurred as of January 1 of the respective year. Although prepared on a basis consistent with Encore’s consolidated financial statements, these unaudited pro forma results do not purport to be indicative of the actual results of operations of the combined companies which would have been achieved had these events occurred at the beginning of the periods presented nor are they indicative of future results (in thousands except per share data):


	Three Months Ended
	April 1,			April 2,
	2006			2005
Net sales	$	108,253		$	94,461
Income before income taxes		(1,590	)		868
Net income (loss)		(2,932	)		519
Basic earnings (loss) per share	$	(0.04	)	$	0.01
Shares used in computing basic earnings (loss) per share		70,344			69,960
Diluted earnings (loss) per share	$	(0.04	)	$	0.01
Shares used in computing diluted earnings (loss) per share		70,344			70,692

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11. INCOME TAXES

Income taxes for the interim periods presented have been included in the accompanying financial statements on the basis of an estimated annual effective tax rate, adjusted for discrete items. During Q1 2006, we recorded approximately $1.3 million of income tax expense on a pre-tax loss of approximately $1.2 million due to the recording of approximately $4.0 million of in-process research and development (“IPR&D”) costs, which are not deductible. We have treated the IPR&D charge as a discrete item, and as such, recorded the entire income tax impact in Q1 2006. Excluding the IPR&D charge, our effective tax rate would have approximated 42%. The increased rate from that we used in 2005 (approximately 40%), principally resulted from our adoption of FAS 123R and the fact that certain of our stock compensation costs are not deductible for income tax purposes.


12.		GUARANTOR / NON-GUARANTOR COMPANIES OF THE 9³/4% SENIOR SUBORDINATED NOTES DUE 2012

Under the terms of our 9³/4% senior subordinated notes due 2012, Encore Medical Corporation and our U.S. subsidiaries guarantee the notes. Our foreign subsidiaries do not guarantee the notes. The subsidiary issuer and each subsidiary guarantor is 100% owned by the parent company. All guarantees are full and unconditional, and are also joint and several among the guarantor companies. The indenture related to our notes imposes certain restrictions including, among other things, limits on our ability and that of our subsidiaries to:

	•		incur or guarantee additional indebtedness or issue preferred stock;

	•		pay dividends or make other distributions;

	•		repurchase our stock;

	•		make investments;

	•		sell or otherwise dispose of assets, including capital stock of subsidiaries;

	•		create liens;

	•		prepay, redeem or repurchase debt;

	•		enter into agreements restricting our subsidiaries’ ability to pay dividends;

	•		enter into transactions with affiliates; and

	•		consolidate, merge or sell all of our assets.

- 15 -

The following condensed consolidating schedules present condensed financial information of our guarantors and our subsidiaries that are non-guarantors as of and for the periods presented below.

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Balance Sheet
As of April 1, 2006
(in thousands)
(unaudited)


	Encore		Encore
	Medical		Medical		Other			Non-		Elim-
	Corporation		IHC, Inc.		Guarantors			guarantors		inations			Consolidated
Assets
Current assets:
Cash and cash equivalents	$	446	$	—	$	17,812		$	4,669	$	—		$	22,927
Accounts receivable, net		—		—		90,171			12,477		—			102,648
Inventories, net		—		—		67,496			6,424		(541	)		73,379
Deferred tax assets		—		—		15,183			79		—			15,262
Prepaid expenses and other current assets		2		329		4,880			638		—			5,849
Assets of discontinued operations		—		—		7			—		—			7

Total current assets		448		329		195,549			24,287		(541	)		220,072

Property and equipment, net		—		—		30,039			7,336		(2,370	)		35,005
Goodwill		—		—		273,182			54,684		—			327,866
Intangible assets, net		—		—		93,458			15,426		—			108,884
Investment in subsidiaries		54,373		308,834		33,399			—		(396,606	)		—
Intercompany receivable		215,199		82,402		813			—		(298,414	)		—
Deferred tax assets		—		—		(—	)		1,889		—			1,889
Other assets		—		10,033		603			117		—			10,753


Total assets	$	270,020	$	401,598	$	627,043		$	103,739	$	(697,931	)	$	704,469


Liabilities, Minority Interests and Stockholders’ Equity
Current liabilities:
Current portion of long-term debt and capital leases	$	—	$	7,134	$	284		$	2,427	$	—		$	9,845
Accounts payable		424		—		14,367			2,896		—			17,687
Accrued expenses		—		9,449		17,028			7,923		—			34,400
Liabilities of discontinued operations		—		—		92			—		—			92

Total current liabilities		424		16,583		31,771			13,246		—			62,024
Long-term debt and capital leases, net of current portion		—		330,642		1,059			—		—			331,701
Deferred tax liabilities		—		—		33,467			7,067		63			40,597
Intercompany payable		—		—		216,345			82,069		(298,414	)		—
Other non-current liabilities		—		—		474			—		—			474

Total liabilities		424		347,225		283,116			102,382		(298,351	)		434,796
Minority interests		—		—		—			747		—			747
Stockholders’ equity		269,596		54,373		343,927			610		(399,580	)		268,926

Total liabilities, minority interests and stockholders’ equity	$	270,020	$	401,598	$	627,043		$	103,739	$	(697,931	)	$	704,469

-16-

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Balance Sheet
As of December 31, 2005
(in thousands)


	Encore		Encore
	Medical		Medical		Other		Non-			Elim-
	Corporation		IHC, Inc.		Guarantors		guarantors			inations			Consolidated
Assets
Current assets:
Cash and cash equivalents	$	308	$	—	$	13,588	$	3,304		$	—		$	17,200
Accounts receivable, net		—		—		48,589		5,220			—			53,809
Inventories, net		—		—		53,668		2,719			46			56,433
Deferred tax assets		—		—		9,538		—			—			9,538
Prepaid expenses and other current assets		1,108		351		2,994		160			—			4,613
Assets of discontinued operations		—		—		14		—			—			14

Total current assets		1,416		351		128,391		11,403			46			141,607

Property and equipment, net		—		—		23,113		5,952			(2,323	)		26,742
Goodwill		—		—		236,892		53,363			—			290,255
Intangible assets, net		—		—		67,047		15,331			—			82,378
Investment in subsidiaries		55,078		206,453		41,182		—			(302,713	)		—
Intercompany receivable		110,924		157,393		—		—			(268,317	)		—
Other assets		—		10,458		597		—			—			11,055


Total assets	$	167,418	$	374,655	$	497,222	$	86,049		$	(573,307	)	$	552,037


Liabilities, Minority Interests and Stockholders’ Equity
Current liabilities:
Current portion of long-term debt and capital leases	$	—	$	7,134	$	143	$	10		$	—		$	7,287
Accounts payable		82		—		10,718		1,020			—			11,820
Accrued expenses		—		5,346		16,707		4,888			—			26,941
Liabilities of discontinued operations		—		—		295		—			—			295

Total current liabilities		82		12,480		27,863		5,918			—			46,343
Long-term debt and capital leases, net of current portion		—		307,099		695		—			—			307,794
Deferred tax liabilities		—		—		23,426		6,150			87			29,663
Intercompany payable		—		—		188,047		80,270			(268,317	)		—
Other non-current liabilities		—		—		460		—			—			460

Total liabilities		82		319,579		240,491		92,338			(268,230	)		384,260
Minority interests		—		—		—		670			—			670
Stockholders’ equity		167,336		55,076		256,731		(6,959	)		(305,077	)		167,107

Total liabilities, minority interests and stockholders’ equity	$	167,418	$	374,655	$	497,222	$	86,049		$	(573,307	)	$	552,037

-17-

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Statement of Operations
Three Months Ended April 1, 2006
(in thousands)
(unaudited)


	Encore		Encore
	Medical		Medical			Other			Non-			Elim-
	Corporation		IHC, Inc.			Guarantors			guarantors			inations			Consolidated
Net sales	$	—	$	—		$	76,741		$	12,809		$	(1,425	)	$	88,125
Cost of sales		—		—			31,241			5,841			(1,375	)		35,707

Gross margin		—		—			45,500			6,968			(50	)		52,418

Operating expenses:
Selling, general and administrative		—		—			33,798			5,444			—			39,242
Research and development		—		—			6,472			376			—			6,848

Operating income		—		—			5,230			1,148			(50	)		6,328

Other income (expense):
Interest income		—		3,776			107			14			(3,776	)		121
Interest expense		—		(7,463	)		(3,820	)		(11	)		3,776			(7,518	)
Other income (expense), net		1,991		5,678			214			(304	)		(7,695	)		(116	)

Income (loss) from continuing operations before income taxes and minority interests		1,991		1,991			1,731			847			(7,745	)		(1,185	)
Provision for income taxes		—		—			965			338			(24	)		1,279
Minority interests		—		—			—			59			—			59

Income (loss) from continuing operations		1,991		1,991			766			450			(7,721	)		(2,523	)

Discontinued operations:
Income (loss) from discontinued operations, net of tax		—		—			(2	)		—			—			(2	)


Net income (loss)	$	1,991	$	1,991		$	764		$	450		$	(7,721	)	$	(2,525	)

-18-

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Statement of Operations
Three Months Ended April 2, 2005
(in thousands)
(unaudited)


	Encore		Encore
	Medical		Medical			Other			Non-			Elim-
	Corporation		IHC, Inc.			Guarantors			guarantors			inations			Consolidated
Net sales	$	—	$	—		$	61,595		$	11,047		$	(1,083	)	$	71,559
Cost of sales		—		—			24,981			5,124			(1,074	)		29,031

Gross margin		—		—			36,614			5,923			(9	)		42,528

Operating expenses:
Selling, general and administrative		—		—			26,862			4,117			—			30,979
Research and development		—		—			2,122			357			—			2,479

Income from continuing operations		—		—			7,630			1,449			(9	)		9,070

Other income (expense):
Interest income		2		—			82			—			—			84
Interest expense		—		(6,975	)		(43	)		21			—			(6,997	)
Other income (expense), net		1,720		8,694			178			(155	)		(10,413	)		24

Income from continuing operations before minority interests and income taxes		1,722		1,719			7,847			1,315			(10,422	)		2,181
Provision for income taxes		—		—			234			642			(3	)		873
Minority interests		—		—			—			26			—			26

Net income from continuing operations		1,722		1,719			7,613			647			(10,419	)		1,282
Income from discontinued operations		—		—			311			—			—			311

Net income	$	1,722	$	1,719		$	7,924		$	647		$	(10,419	)	$	1,593

-19-

ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Statement of Cash Flows
Three Months Ended April 1, 2006
(in thousands and unaudited)


	Encore			Encore
	Medical			Medical			Other			Non			Elim-
	Corporation			IHC, Inc.			Guarantors			guarantors			inations			Consolidated
OPERATING ACTIVITIES:
Net loss	$	1,991		$	1,991		$	764		$	450		$	(7,721	)	$	(2,525	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation		—			—			1,687			686			(39	)		2,334
Amortization of intangibles		—			—			1,050			416			—			1,466
Amortization of debt issuance costs		—			542			—			—			—			542
Non-cash interest expense		—			27			—			—			—			27
Stock-based compensation		—			—			823			—			—			823
Loss on disposal of assets		—			—			219			85			(82	)		222
Deferred income taxes		—			—			99			(149	)		(24	)		(74	)
Income from subsidiaries		(1,991	)		(4,769	)		(350	)		—			7,110			—
Provision for bad debt expense and sales returns		—			—			1,986			93			—			2,079
Inventory reserves		—			—			1,012			52			—			1,064
Minority interests		—			—			—			59			—			59
Excess tax benefit associated with stock option exercises		—			—			(945	)		—			—			(945	)
In-process research and development		—			—			4,016			—			—			4,016
Net effect of discontinued operations		—			—			(196	)		—			—			(196	)

Changes in operating assets and liabilities, net of acquired assets and liabilities:
Accounts receivable		—			—			(6,383	)		918			—			(5,465	)
Inventories		—			—			(2,584	)		(221	)		588			(2,217	)
Prepaid expenses, other assets and liabilities		1,106			19			(837	)		(105	)		—			183
Accounts payable and accrued expenses		341			4,103			(2,484	)		(2,839	)		—			(879	)

Net cash provided by operating activities		1,447			1,913			(2,123	)		(555	)		(168	)		514

INVESTING ACTIVITIES:
Acquisition of businesses, net of cash acquired		—			(233	)		(2	)		—			—			(235	)
Proceeds on sale of assets		—			—			61			—			—			61
Purchases of property and equipment		—			—			(3,151	)		(850	)		168			(3,833	)
Acquisition of intangibles		—			—			(250	)		(134	)		—			(384	)

Net cash used in investing activities		—			(233	)		(3,342	)		(984	)		168			(4,391	)

FINANCING ACTIVITIES:
Proceeds from issuance of common stock		2,416			—			—			—			—			2,416
Intercompany		(3,725	)		(25,197	)		24,006			4,916			—			—
Excess tax benefit associated with stock option exercises		—			—			945			—			—			945
Proceeds from long-term obligations		—			25,300			—			—			—			25,300
Payments on long-term obligations		—			(1,783	)		(15,262	)		(2,096	)		—			(19,141	)

Net cash provided by financing activities		(1,309	)		(1,680	)		9,689			2,820			—			9,520
Effect of exchange rate on cash and cash equivalents		—			—			—			84			—			84

Net decrease in cash and cash equivalents		138			—			4,224			1,365			—			5,727

Cash and cash equivalents at beginning of year		308			—			13,588			3,304			—			17,200

Cash and cash equivalents at end of period	$	446		$	—		$	17,812		$	4,669		$	—		$	22,927

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ENCORE MEDICAL CORPORATION AND SUBSIDIARIES

Condensed Consolidating Statement of Cash Flows
Three Months Ended April 2, 2005
(in thousands and unaudited)


	Encore			Encore
	Medical			Medical			Other			Non-			Elim-
	Corporation			IHC, Inc.			Guarantors			guarantors			inations			Consolidated
OPERATING ACTIVITIES:
Net income	$	1,722		$	1,719		$	7,924		$	647		$	(10,419	)	$	1,593
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation		—			—			1,306			737			—			2,043
Amortization of intangibles		—			—			789			421			—			1,210
Amortization of debt issuance costs		—			553			—			—			—			553
Non-cash interest expense		—			24			—			—			—			24
Stock-based compensation		—			—			38			—			—			38
(Gain) loss on disposal of assets		—			—			(97	)		304			—			207
Deferred income taxes		—			(3,651	)		6,035			262			—			2,646
Provision for bad debt expense and sales returns		—			—			1,096			36			—			1,132
Inventory reserves		—			—			1,484			—			—			1,484
Minority interests		—			—			—			26			—			26
Tax benefit associated with stock options		(49	)		—			—			—			—			(49	)
Net effect of discontinued operations		—			—			88			—			—			88
Changes in operating assets and liabilities, net of acquired assets and liabilities:
Accounts receivable		—			—			3,129			(277	)		—			2,852
Inventories		—			—			(4,458	)		(191	)		9			(4,640	)
Prepaid expenses, other assets and liabilities		4			—			(1,987	)		(283	)		—			(2,266	)
Accounts payable and accrued expenses		(2	)		(3,877	)		(2,700	)		(713	)		(3	)		(7,295	)

Net cash used in operating activities		1,675			(5,232	)		12,647			969			(10,413	)		(354	)
INVESTING ACTIVITIES:
Acquisition of businesses, net of cash acquired		—			(156	)		(15,090	)		—			—			(15,246	)
Investment in subsidiaries		(1,719	)		(8,694	)		—			—			10,413			—
Purchases of property and equipment		—			—			(1,385	)		(663	)		—			(2,048	)
Net effect of discontinued operations		—			—			(2	)		—			—			(2	)

Net cash used in investing activities		(1,719	)		(8,850	)		(16,477	)		(663	)		10,413			(17,296	)
FINANCING ACTIVITIES:
Proceeds from issuance of common stock		48			—			—			—			—			48
Proceeds from notes received for sale of common stock		102			—			—			—			—			102
Intercompany		3,177			1,423			(5,476	)		876			—			—
Proceeds from long-term obligations		—			14,700			—			—			—			14,700
Payments on long-term obligations		—			(1,875	)		(230	)		(21	)		—			(2,126	)
Payment of debt issuance costs		—			(166	)		—			—			—			(166	)
Dividend paid to minority interests		—			—			—			(198	)		—			(198	)

Net cash provided by financing activities		3,327			14,082			(5,706	)		657			—			12,360
Effect of exchange rate on cash and cash equivalents		—			—			28			(315	)		—			(287	)
Net decrease in cash and cash equivalents		3,283			—			(9,508	)		648			—			(5,577	)
Cash and cash equivalents at beginning of period		739			—			15,223			3,927			—			19,889

Cash and cash equivalents at end of period	$	4,022		$	—		$	5,715		$	4,575		$	—		$	14,312

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

Introduction

This management’s discussion and analysis of financial condition and results of operations is intended to provide an understanding of our results of operations, financial condition and where appropriate, factors that may affect future performance. We will discuss and provide our analysis of the following:

	•		Overview of Business and First Quarter Results

	•		Results of Operations

	•		Critical Accounting Policies and Estimates

	•		Recent Accounting Pronouncements

	•		Liquidity and Capital Resources

The following discussion should be read in conjunction with the Consolidated Financial Statements and related notes for those financial statements as well as the other financial data included elsewhere in this Form 10-Q.

Overview of Business and First Quarter Results

We are a diversified orthopedic device company that develops, manufactures and distributes a comprehensive range of high quality orthopedic devices including sports medicine equipment and products for orthopedic rehabilitation, pain management and physical therapy and surgical implants. Our products are used by orthopedic surgeons, physicians, therapists, athletic trainers, and other healthcare professionals to treat patients with musculoskeletal conditions resulting from degenerative diseases, deformities, traumatic events and sports-related injuries, and a substantial amount of our non-invasive medical devices and related accessories are primarily used by patients for at-home physical therapy. We currently market and distribute our products through two operating divisions, as follows:

	•		*Orthopedic Rehabilitation Division.*Our Orthopedic Rehabilitation Division offers non-invasive medical products that are used before and after surgery to assist in the repair and rehabilitation of soft tissue and bone, and to protect against further injury; electrotherapy, patient care and continuous passive motion devices and accessories used to treat pain and restore muscle function; iontophoretic devices and accessories used to deliver medication; clinical therapy tables and traction equipment; physical therapy traction and treatment tables, chiropractic treatment tables and orthotics devices used to treat joint and spine conditions.

	•		*Surgical Implant Division.*Our Surgical Implant Division offers a comprehensive product offering comprised of reconstructive joint products and spinal implants.

Our two divisions enable us to reach a diverse customer base through multiple distribution channels and give us the opportunity to provide a comprehensive range of orthopedic devices and related products to orthopedic specialists operating in a variety of treatment settings for their patients.

In recent years, our growth has been driven both by the introduction of products facilitated by our research and development efforts and selected acquisitions of businesses or products in the orthopedic industry. During the first quarter of 2006, we completed our acquisition of Compex Technologies, Inc. (“Compex”). This acquisition expanded upon our at-home therapy product lines acquired from Empi, Inc. (“Empi”) in October 2004. In addition since 2001, we have completed two other acquisitions which have enhanced our presence in the orthopedic market and expanded the product lines offered by our Orthopedic Rehabilitation Division to include electrotherapy, rehabilitation equipment and related products. Our February 2005 acquisition of the assets of Osteoimplant Technology, Inc. (“OTI”) added the Advanced Spine spinal implant product line and total knee and hip implant designs to our Surgical Implant Division’s existing product offerings.

The nature of our business requires significant investment in accounts receivable, inventory, new product development and debt service requirements. We have a diverse group of customers to whom we sell our products. In order to collect our revenues, we employ a variety of processes tailored to meet the needs of our customers. In addition, our customers expect us to maintain sufficient inventory on hand at all times to meet their needs. Many of our domestic customers require consignment product to be placed at or near their respective locations. Our remaining customers across

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all product lines demand short delivery schedules for their orders. Finally, our growth is driven by new product development and selected acquisitions. These initiatives demand investment in development efforts and currently require us to meet significant debt service requirements.

On August 8, 2005, we completed the sale of our soft goods product line to dj Orthopedics, LLC (“dj”) for a cash payment of approximately $9.5 million. The sale to dj of our former soft goods product line in the third quarter of 2005 enabled us to use after-tax net proceeds to reduce our debt and provided expansion space for our growing Surgical Implant Division operations. For accounting purposes, the operating results of the soft goods product line and the gain on asset sale associated with this transaction have been classified as discontinued operations in the consolidated statements of operations for all historical periods presented in this report.

Our net sales increased 23.2% in the first quarter of 2006 to $88.1 million compared to $71.6 million in the quarter ended April 2, 2005. Our first quarter 2006 comparative operating performance was driven by continued growth in both our Orthopedic Rehabilitation and Surgical Implant Divisions along with one month of revenue contribution from our Compex acquisition. Gross margin as a percentage of our net sales increased to 59.5% in the first quarter of 2006 from 59.4% in the first quarter of 2005. Our operating income of $6.3 million for the first quarter of 2006 decreased from $9.1 million in the same period of 2005 due to (i) a $4.0 million charge for in-process research and development costs stemming from our Compex acquisition, (ii) $280,000 of expense related to the write up to fair market value of inventory acquired in the Compex acquisition, with the remainder to be expensed by the end of the second quarter of 2006, and (iii) $818,000 of stock based compensation expense resulting from the implementation of SFAS 123(R) in the first quarter of 2006. We recorded a loss from continuing operations of $2.5 million, or $0.04 of diluted earnings per share in the first quarter of 2006 compared to income from continuing operations of $1.3 million, or $0.02 of diluted earnings per share, in the first quarter of 2005. In the first quarter of 2006, we had 59.0 million diluted shares outstanding, compared to 52.4 million diluted shares outstanding in the same period last year.

Results of Operations

The following table sets forth our statements of operations as a percentage of sales for the periods indicated:


	Three Months Ended
	April 1,			April 2,
	2006			2005
Net sales		100.0	%		100.0	%
Cost of sales		40.5			40.6

Gross margin		59.5			59.4
Operating expenses:
Selling, general and administrative		44.5			43.3
Research and development		7.8			3.4

Operating income		7.2			12.7
Other income (expense):
Interest income		0.1			0.1
Interest expense		(8.5	)		(9.8	)
Other income (expense), net		(0.1	)		—

Income (loss) from continuing operations before income taxes and minority interests		(1.3	)		3.0
Provision for income taxes		1.5			1.2
Minority interests		0.1			—

Income (loss) from continuing operations		(2.9	)		1.8
Discontinued operations:
Income (loss) from discontinued operations (net of income tax expense)		—			0.4

Net income (loss)		(2.9	%)		2.2	%

Three Months Ended April 1, 2006, as Compared to the Three Months Ended April 2, 2005

Net sales.Our net sales for the quarter ended April 1, 2006 were $88.1 million, representing an increase of 23.2% over net sales of $71.6 million in the quarter ended April 2, 2005, driven by continued growth in both our Orthopedic Rehabilitation and Surgical Implant Divisions. Our domestic net sales increased 26.0% to $70.0 million in the first quarter of 2006 from $55.5 million in the first quarter of 2005. Our foreign net sales increased 13.1%, to $18.1 million for the first three months of 2006 from $16.0 million for the same period in 2005.

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The following table sets forth the geographic mix of our net sales for the first quarter of 2006 compared to the first quarter of 2005.


	Domestic							International							Total
					%							%							%
(In thousands, except %)	2006		2005		Growth			2006		2005		Growth			2006		2005		Growth
Orthopedic Rehabilitation Division	$	56,970	$	44,743		27.3	%	$	15,730	$	14,525		8.3	%	$	72,700	$	59,268		22.7	%
Surgical Implant Division		13,042		10,806		20.7	%		2,383		1,485		60.5	%		15,425		12,291		25.5	%

Total	$	70,012	$	55,549		26.0	%	$	18,113	$	16,010		13.1	%	$	88,125	$	71,559		23.2	%

Our Orthopedic Rehabilitation Division achieved net sales of $72.7 million during the first quarter of 2006, which was an increase of 22.7% over revenue of $59.3 million in the first quarter of 2005, led by continued growth in our clinical electrotherapy, home electrotherapy and catalogue products. The Division also benefited from one month of revenue contribution from our Compex acquisition.

Our Surgical Implant Division achieved net sales of $15.4 million in the first quarter of 2006, a 25.5% increase over the same period in the prior year. Domestic Surgical Implant Division sales for the first quarter of 2006 grew 20.7% to $13.0 million compared to $10.8 million in the first quarter of 2005. International sales of $2.4 million in the first quarter of 2006 grew 60.5% over the prior year’s first quarter sales of $1.5 million. Revenue growth in our Surgical Implant Division was driven primarily by growth in our knee, hip and shoulder product lines, increased international market penetration and sales of Advanced Spine^TM and other total joint products from our February 2005 acquisition of the assets of Osteoimplant Technologies, Inc. (“OTI”).

In the first quarter of 2006, our sales of new products, which are products that have been on the market less than one year, were $5.9 million compared to first quarter 2005 new product sales of $2.2 million.

Gross margin.Our overall gross margin as a percentage of net sales increased to 59.5% in the first quarter 2006 from 59.4% in the first quarter of 2005. Gross margin in the first quarter of 2006 was negatively impacted by $280,000 of expense related to the write up to fair market value of inventory acquired in the Compex acquisition. Our Orthopedic Rehabilitation Division gross margin of 55.9%, compared to that division’s gross margin of 55.2% in the first quarter of 2005, was negatively impacted by the inventory write up expense described above and positively impacted by one month of gross margin contribution from our Compex acquisition. Surgical Implant Division gross margin of 76.4% in the first quarter of 2006 compared to gross margin of 79.9% in the first quarter of 2005, due primarily to growth in international sales, which are at a lower comparative gross margin.

Selling, General and Administrative.Our selling, general, and administrative expenses increased to $39.2 million in the first quarter of 2006 from $31.0 million in the first quarter of 2005. As a percentage of net sales, selling, general, and administrative expenses increased to 44.5% from 43.3% in the prior year first quarter. Increased selling, general and administrative expenses associated with Compex, and higher commissions and royalties associated with increased sales comprise the majority of this increase. In addition, we recorded approximately $800,000 of employee stock compensation in the first quarter of 2006 in connection with the implementation of SFAS 123(R) as of January 1, 2006.

Research and Development. Our research and development expenses increased significantly to $6.8 million for the first quarter of 2006 from $2.5 million for the first quarter of 2005. In connection with the Compex acquisition, we recognized $4.0 million of in-process research and development costs. The addition of Compex research and development expenses and higher product development costs also contributed to this increase.

Operating Income.Our operating income of $6.3 million or 7.2% of revenue, in the first quarter of 2006 compared to operating income of $9.1 million, or 12.7% of revenue, in the first quarter of 2005. Operating income in the first quarter was negatively impacted by approximately $4.0 million of expense related to the write off of in-process research and development associated with the Compex acquisition and $280,000 of expense related to the write up of inventory acquired in the Compex acquisition to fair market value. In addition, we incurred $818,000 of stock based compensation expense in the first quarter of 2006.

Interest Expense.Our interest expense increased to $7.5 million in the first quarter of 2006 compared to interest expense of $7.0 million in the first quarter of 2005. The comparative increase in first quarter 2006 interest expense over the prior year period was principally driven by higher interest rates on the floating portion of the Company’s outstanding

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indebtedness and increased borrowings to finance the OTI acquisition in February 2005 along with borrowings in connection with the Compex acquisition in February 2006.

Provision for Income Taxes. For the first quarter of 2006, we recorded approximately $1.3 million of income tax expense on a per-tax loss of approximately $1.2 million due to the recording of approximately $4.0 million of in-process research and development (“IPR&D”) costs, which are not deductible. We have treated the IPR&D charge as a discrete item, and as such, recorded the entire income tax impact in Q1 2006. Excluding the IPR&D charge, our effective tax rate would have approximated 42%. The increased rate from that we used in 2005 (approximately 40%), principally resulted from our adoption of FAS 123R and the fact that certain of our stock compensation costs are not deductible for income tax purposes.

Net Income.We recognized a net loss for the first quarter of 2006 of $2.5 million, or $0.04 of diluted earnings per share, compared to net income of $1.6 million or $0.03 of diluted earnings per share ($0.02 from continuing operations, $0.01 from discontinued operations), in the first quarter of 2005 based on the factors discussed above.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, management evaluates estimates, including those related to revenue recognition, goodwill and intangible assets, deferred taxes, and inventory. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. To the extent that actual events differ from our estimates and assumptions, there could be a material impact to our financial statements.

Revenue Recognition

We recognize revenue when (1) persuasive evidence of an arrangement exists, (2) the price is fixed or determinable, (3) delivery has occurred and (4) collectibility is reasonably assured.

We sell our Orthopedic Rehabilitation Division products through a variety of distribution channels. We sell our clinical rehabilitation products to dealers. We record sales at the time the product is shipped to the dealer. Dealers take title to the products, assume credit and product obsolescence risks, must pay within specified periods regardless of when they sell or use the products and have no price protection. For our home therapy products, we recognize wholesale revenue when we ship our products to our wholesale customers. We recognize home therapy retail revenue, both rental and purchase, when our product has been dispensed to the patient and the patient’s insurance has been verified. We recognize revenue for product shipped directly to the patient at the time of shipment. For retail products that are sold from our inventories consigned at clinic locations, we recognize revenue when we receive notice that the device has been prescribed and dispensed to the patient and the insurance has been verified or preauthorization from the insurance company has been obtained, when required.

We sell our Surgical Implant Division products through a network of independent sales representatives in the United States, as well as distributors outside the United States. We record revenues from sales made by sales representatives, who are paid commissions upon the ultimate sale of the products, at the time the product is used in a surgical procedure (implanted in a patient) and a purchase order is received from the hospital. We record revenues from sales to customers outside the United States at the time the product is shipped to the distributor. Our international distributors, who sell the products to their customers, take title to the products, have no rights of return except in certain limited instances following a change of control of Encore, and assume the risk for credit and obsolescence. Distributors are obligated to pay us within specified terms, regardless of when they sell the products. In addition, there is no price protection available to distributors.

Reserves for Sales Allowances, Product Returns and Rental Credits. We have established reserves to account for sales allowances, product returns and rental credits. Significant management judgment must be used and estimates made in connection with establishing the sales returns and other allowances in any accounting period.

Our reserves for sales allowances account for sales of our products below the invoice price. These sales generally result from agreements that we enter into with certain customers that permit them to pay us for our products in amounts that are below the invoice price of the product. We estimate the amount of the reduction based on historical experience and invoices generated in the period, and we consider the impact of new contract terms or modifications of existing arrangements with our customers. We provide for these reserves by reducing our gross revenue.

Our reserve for product returns accounts for customer returns of our products after purchase. These returns are mainly attributable to a third-party payor’s refusal to provide a patient release or reimbursement for the product or the inability of the product to adequately address the patient’s condition. We provide for this reserve by reducing gross revenue by an amount based on our historical rate of returns.

Our reserve for rental credit recognizes a timing difference between billing of a purchase and processing of a rental credit associated with some of our rehabilitation devices. Many insurance providers require patients to rent our

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rehabilitation devices for a period of one to three months prior to purchase. If the patient has a long-term need for the device, these insurance companies may authorize purchase of the device after such time period. When the device is purchased, most providers require that rental payments previously made on the device be credited toward the purchase price. These credits are processed at the time the payment is received for the purchase of the device, which creates a time lag between billing of the purchase and processing of the rental credit. Our rental credit reserve accounts for unprocessed rental credits based on the number of devices converted to purchase. The reserve is calculated by first assessing the number of our products being rented during the relevant period and our historical conversion rate of rentals to sales, and then reducing our revenue by the applicable amount. We provide for these reserves by reducing our gross revenue. The cost to refurbish rented products is expensed as incurred as part of cost of sales.

Reserve for Uncollectible Accounts Receivable.In addition to the reserves for sales allowances, returns and rental credits, we have also established a reserve for uncollectible accounts receivable. These uncollectible accounts are a result of nonpayment from our customers and patients. The reserve is based on historical trends and current relationships with our customers and providers. Additions to this reserve are reflected in selling, general, and administrative expense.

Goodwill and Intangible Assets

We must make estimates related to the initial recognition and measurement of intangible assets acquired in connection with a business combination or asset acquisition, as well as the ongoing measurement of the useful life and value of intangible assets and goodwill. With respect to valuations of intangible assets acquired in connection with a business combination or asset acquisition, we use external third party evaluations in determining the respective fair values and relative allocations of acquisition cost to the assets acquired and liabilities assumed. We periodically evaluate whether events and circumstances have occurred which may affect the estimated useful life, or the recoverability of the remaining balances of our goodwill and other intangible assets. If such events or circumstances were to indicate that the carrying amount of those assets would not be recoverable, we would estimate the future cash flows expected to result from the use of the assets and their eventual disposition. In the fourth quarter, we perform an annual test of our goodwill and intangible assets for potential impairment. The process of evaluating the potential impairment is subjective and requires us to exercise judgment in making assumptions related to future cash flows and discount rates. If the sum of the expected future cash flows (undiscounted and without interest charges) were less than the carrying amount of goodwill and other long-lived assets, we would recognize an impairment loss.

Any impairment of an intangible asset or goodwill would require a reduction in the value of the asset on our consolidated balance sheet and a charge to operating income on our consolidated statement of operations. The nature of the charge to operating income would be determined based upon the nature of the intangible asset or goodwill requiring the adjustment.

At April 1, 2006, we have goodwill and intangible assets as follows (in thousands):


	Goodwill		Intangibles, net
Orthopedic Rehabilitation Division	$	317,610	$	105,243
Surgical Implant Division		10,256		3,641

Total	$	327,866	$	108,884

Deferred Tax Asset Valuation Allowance

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amount and the tax bases of assets, liabilities and net operating loss carryforwards. We establish valuation allowances when the recovery of a deferred tax asset is not likely based on historical income, projected future income, the expected timing of the reversals of temporary differences and the implementation of tax-planning strategies.

Our gross deferred tax asset balance is approximately $21.9 million at April 1, 2006 and primarily relates to receivable and inventory reserves, accrued compensation and net operating loss carryforwards. As of April 1, 2006, we have recorded a valuation allowance of $2.4 million due to uncertainties related to our ability to realize certain foreign net operating loss carryforwards acquired in connection with the Empi and Compex acquisitions.

Inventory Reserves

The nature of our business requires us to maintain sufficient inventory on hand at all times to meet the requirements of our customers. We record inventory at the lower of cost or market, with cost based upon average actual cost. We maintain inventory reserves for such issues as slow moving or excess inventory, product obsolescence and declines in value. In each division we use a specific identification methodology, adjustments to which can occur whenever there is a change in

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strategy. In addition, we review sales performance on at least a quarterly basis to determine the amounts that we should add to the existing reserve. To determine the adequacy of our reserves at each reporting date we analyze the following, among other factors:

	•		Current inventory quantities on hand;

	•		Product acceptance in the marketplace;

	•		Customer demand;

	•		Historical sales;

	•		Forecasted sales;

	•		Product obsolescence; and

	•		Technological innovations.

If there is a material change due to the factors listed above, the current level of the reserve for inventory may not be adequate and would result in our increasing the reserve level. Any modifications to our estimates of our reserves are reflected in cost of sales within the statement of operations, during the period in which such modifications are determined necessary by management.

Our Orthopedic Rehabilitation Division consigns a portion of its inventory to clinics and other healthcare provider locations to allow its products to be immediately dispensed to patients. Our Surgical Implant Division products are sold in the United States at the time the product is used in a surgical procedure. As such, this division also consigns product at many locations throughout the country. This requires a large amount of inventory to be on hand for the products we sell on consignment. It also increases the sensitivity of these products to obsolescence reserve estimates. Because this inventory is not in our possession, we also reserve for these products based on the results of periodic inventory counts and historical trends.

Recent Accounting Pronouncements

In June 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APB Opinion No. 20, “Accounting Changes”, and FASB SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements”. The Statement changes the accounting for, and reporting of, a change in accounting principle. SFAS 154 applies to all voluntary changes in accounting principles and changes required by an accounting standard when the standard does not include specific transition provisions and is effective for accounting changes and corrections of errors in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 did not have a material impact on our financial condition, results of operations or cash flows.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (“SFAS 151”), an amendment of ARB No. 43, which is the result of its efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS 151 requires idle facility expenses, freight, handling costs, and wasted material (spoilage) costs to be recognized as current-period charges. It also requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS 151 did not have a material impact on our financial condition, results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment” (“SFAS 123R”). This Statement revised SFAS No. 123 (“SFAS 123”) by eliminating the option to account for employee stock options under APB No. 25 and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards.

Effective January 1, 2006, we adopted SFAS 123R using the modified prospective method, in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123R for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date.

As permitted under SFAS 123, we elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations in accounting for stock-based awards to employees prior to January 1, 2006. Accordingly, we measured compensation cost for stock options as the excess, if any, of the market price of our common stock at the date of grant over the exercise price. Historically, we had recognized no compensation cost under APB 25.

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15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123R requires us to reflect the tax savings resulting from tax deductions in excess of expense reflected in its financial statements as a financing cash flow.


Stock-option compensation expense recognized:
Cost of sales	$	16
Selling, general and administrative		794
Research and development		8

Total	$	818
Related deferred income tax benefit		110
Decrease in net income	$	708

Impact on basic and diluted net loss per common share	($	0.01	)

Liquidity and Capital Resources

During our quarter ended April 1, 2006, our operating activities provided $514,000 of cash and cash equivalents as compared to our quarter ended April 2, 2005 when our operating activities used cash of $354,000 an improvement of $868,000. In the first quarter of 2006, cash used for inventory, prepaids and accounts payable and accrued expenses declined in comparison to the first quarter of 2005 while cash used for accounts receivable increased, resulting in a net improvement in cash flow from operating assets and liabilities of $3.0 million. This improvement was offset by a $1.2 million reduction in our cash flow related to net income, adjusted for noncash items, from the first quarter of 2006 of $9.8 million compared to the first quarter of 2005 of $11.0 million. In addition, prior to the adoption of SFAS 123R, we presented the tax savings resulting from tax deductions resulting from the exercise of stock options as an operating cash flow, in accordance with EITF 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123R requires us to reflect the tax savings resulting from tax deductions in excess of expense reflected in our financial statements as a financing cash flow. For the quarter ended April 1, 2006, our excess tax benefit associated with stock option exercises totaled approximately $945,000, and this reclassification resulted in a decrease in our operating cash flow of $945,000.

Investing activities used $4.4 million of cash in the first quarter of 2006 compared to $17.3 million in the first quarter of 2005, a $12.9 million decline of cash used for investing activities primarily resulting from our OTI acquisition in February 2005. We used a $15.2 million in cash in the first quarter of 2005 to purchase the assets of OTI. In contrast, our first quarter 2006 acquisition of Compex was purchased through the issuance of stock. This $15.0 million increase in cash flow related to acquisitions was offset by an additional $1.8 million of cash used for purchases of property and equipment compared to the first quarter of 2005.

Cash provided by financing activities in the first quarter of 2005 of $9.5 million decreased $2.9 million from the first quarter of 2005, when cash provided by financing activities was $12.4 million. Our net borrowings, or the difference between proceeds from borrowings and related debt payments, provided $6.2 million of cash in the first quarter of 2006, a net decrease in cash from net borrowings of $6.4 million compared to net borrowings of $12.6 million in the first quarter of 2005. In the first quarter of 2006, we borrowed $25.3 million under our revolving credit facility in connection with our Compex acquisition, and we paid $19.1 million on long-term debt, $17.3 million of which represented a retirement of bank debt acquired from Compex. In the first quarter of 2005, we borrowed $14.7 million under our revolving credit facility to finance our acquisition of OTI. We also paid $2.1 million on long-term debt representing our regularly scheduled principal payments. In addition, during the first quarter of 2006, we received approximately $2.4 million in proceeds from option exercises principally by former Compex executives. Finally, we received $945,000 of excess tax benefit associated with the exercise of these stock options.

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Since our inception, we have financed our operations through the sale of equity securities, borrowings and cash flow from operations. We believe there is sufficient liquidity to fund current operations and contingencies. In connection with our Compex acquisition, our revolving credit facility was increased from $30 million to $50 million. As a result, on February 24, 2006 our senior credit facility with a syndicate of banks, financial institutions and other institutional lenders led by Bank of America, N.A., provides for aggregate borrowings of up to $200 million, comprised of a five-year $50 million revolving credit facility, and a six-year $150 million term loan facility (the “Credit Facility”). Proceeds from the term loan facility were used to finance the cash portion of our purchase of Empi. In February 2005, we borrowed $14.7 million from our existing line of credit to finance the purchase of OTI. During the first quarter of 2006, we borrowed $25.3 million from our revolving credit facility in connection with our Compex acquisition. The remaining $10 million available under our revolving credit facility as of April 1, 2006 can be used for general corporate purposes, subject to certain limitations. We executed various security documents, and we pledged to the lenders all of our domestic assets and 66% of the equity holdings of our foreign subsidiaries to secure the financing under the Credit Facility. The interest rate under the Credit Facility is dependent upon, among other things, our total debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio. Based on that ratio as of April 1, 2006, our interest rate is 7.34% and is equal to Bank of America’s base rate plus 0.5%, or the London Interbank Offered Rate (LIBOR) plus 3.00%. Our outstanding balance owed under our Credit Facility was $173.7 million as of April 1, 2006.

Our term loan facility is payable in quarterly installments of principal of (a) $1.8 million, for each of the next seven quarterly periods, (b) $3.6 million, for each of the following eight quarterly periods, and (c) $23.2 million, for each of the last four quarterly periods, with the last payment due in October 2010.

Additionally, on October 4, 2004, we sold to investors $165 million in aggregate principal amount of 9³/4% senior subordinated notes due 2012 (the “notes”) at a purchase price of 99.314% of the principal amount of the notes. Interest on the notes accrues at the rate of 9³/4% per annum and is payable semi-annually on April 1 and October 1. The lenders’ rights under the notes are junior and subordinate to the rights of the various lenders and the security interests created by the security documents executed pursuant to the Credit Facility. We owed $164 million in principal amount of the notes on April 1, 2006.

These debt arrangements contain operating and financial agreements and restrictions, which may restrict our business and financing activities. These debt agreements restrict our ability to (i) incur additional indebtedness; (ii) issue redeemable equity interests and preferred equity interests; (iii) pay dividends or make distributions, repurchase equity interests or make other restricted payments; (iv) make capital expenditures; (v) create liens; (vi) enter into transactions with our affiliates; (vii) make investments; (viii) sell assets; or (ix) enter into mergers or consolidations. The debt agreements also require us to meet certain financial tests. As of the date of this report, we are in compliance with all debt covenants and warranties.

We believe that our existing cash, plus the amounts we expect to generate from operations and amounts available through our remaining revolving credit facility, will be sufficient to meet our operating needs for the next twelve months, including working capital requirements, capital expenditures, debt repayment obligations and potentially smaller product acquisitions.

While we currently believe that we will be able to meet all of our financial covenants imposed by our credit agreements, there is no assurance that we will in fact be able to do so or that, if we do not, we will be able to obtain from our lenders waivers of default or amendments to our credit agreements in the future.

We continue to expand our business through selected acquisitions of businesses or products in the orthopedic industry. We have completed five acquisitions since 2000 that have allowed us to extend our business in the orthopedic market to include rehabilitation equipment and to expand our surgical implant product offerings. We have a history of raising capital through a combination of debt and equity offerings to finance these acquisitions. As additional financing needs arise, we will consider sources of financing to include a combination of debt or equity. We may issue debt or equity in anticipation of future financing needs, to position our capital structure towards a certain debt-to-equity range or to replace existing borrowing agreements.

In addition to the current restrictions and requirements contained in our current loan and credit agreements, the maximum amounts we are contractually permitted to borrow under our current credit facilities could limit our flexibility in obtaining additional financing and in pursuing other business opportunities. This potential high degree of leverage could have negative consequences for us, including the following: (i) our ability to obtain additional financing, if necessary, for working capital, capital expenditures, acquisitions or other purposes may be impaired or financing may not be available to us on favorable terms; (ii) we would need a substantial portion of our cash flow to pay the principal and interest on our indebtedness, including indebtedness that we may incur in the future; (iii) payments on our indebtedness would reduce the funds that would otherwise be available for operations and future business opportunities; (iv) a substantial decrease in net

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operating cash flows could make it difficult for us to meet our debt service requirements and force us to modify our operations; (v) our debt level could make us more vulnerable than our competitors to a downturn in either our business or the economy generally; and (vi) because some of our debt has a variable rate of interest, it would expose us to the risk of increased interest rates.

Related Party Transaction

During the first quarter of 2005, a portion of the total consideration paid for the acquisition of OTI was used to repay a $96,000 note payable due from OTI to Windy City, Inc. (“Windy City”) Joel Kanter, a member of our board of directors, is an officer and director of Windy City. In connection with the acquisition, a finder’s fee obligation of OTI to Mr. Kanter in the amount of $60,000 was also paid to Mr. Kanter at the closing of the OTI acquisition.

Forward Looking Statements

The foregoing management’s discussion and analysis contains various “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that represent our expectations or beliefs concerning future events, including, but not limited to, statements regarding growth in sales of our products, profit margins and the sufficiency of our cash flow for future liquidity and capital resource needs. These forward-looking statements are further qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include, without limitation, the effect of competitive pricing, our dependence on the ability of our third-party manufacturers to produce components on a basis that is cost-effective to us, market acceptance of our products, the ability to attract and retain competent employees, technological obsolescence of one or more products, changes in product strategies, the availability to locate acceptable acquisition candidates and then finance and integrate those acquisitions and effects of government regulation. Results actually achieved may differ materially from expected results included in these statements as a result of these or other factors.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certain market risks as part of our ongoing business operations, primarily risks from changing interest rates and foreign currency exchange rates that could impact our financial condition, results of operations, and cash flows. Our primary exposure is to changing interest rates. We are exposed to interest rate risk in connection with our Credit Facility, which bears interest at floating rates based on the London Interbank Offering Rate (LIBOR) or Bank of America’s base rate plus 0.5%. Our outstanding balance under this agreement was $173.7 million as of April 1, 2006.

We manage our interest rate risk by balancing the amount of fixed and variable debt. For fixed rate debt, interest rate changes affect the market value, but do not impact earnings or cash flow. Conversely, for variable rate debt, interest rate changes generally do not affect the fair market value, but do impact future earnings and cash flow, assuming other factors are held constant. Our $200 million credit facility is based on variable interest rates. As of April 1, 2006, utilizing a hedging strategy, we have swapped variable rates for fixed rates on $50 million of the borrowing under the Credit Facility thereby locking in a fixed rate on this portion of the principal. A hypothetical 1% increase in variable interest rates for the Credit Facility would have impacted our earnings and cash flow, for the quarter ended April 1, 2006, by approximately $1.2 million. All of our other debt is fixed rate debt. We may use additional derivative financial instruments where appropriate to manage our interest rate risk. However, as a matter of policy, we do not enter into derivative or other financial investments for trading or speculative purposes.

In recent years, in particular with the Empi acquisition and expanding as a result of the Compex acquisition, we have begun to directly distribute our Orthopedic Rehabilitation Division products in selected foreign markets, and some of the sales of our products in European markets are denominated in euros, which would cause currency fluctuations to more directly impact our operating results. During the first quarter of 2006, our average monthly euro sales approximated $4.7 million.

Our German subsidiary, whose functional currency is euros, is billed for certain inventory in U.S. dollars. Our U.S. operations are subject to risk associated with international currency exchange rates on purchases of inventory from a small number of suppliers. In addition, our Swiss subsidiary, acquired as part of the Compex acquisition whose functional currency is euros, must pay a portion of its operating expenses in Swiss francs. Our German subsidiary periodically utilizes international currency derivatives to limit its risk to currency fluctuations. These derivatives are in the form of forward currency contracts used to manage currency fluctuation on purchases of inventory that are denominated in U.S. dollars. We did not have any foreign currency derivatives outstanding as of April 1, 2006.

To date, we have not used international currency derivatives to hedge against our investment in our German subsidiary or its operating results, which are converted into U.S. dollars at period-end and average rates, respectively.

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ITEM 4. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

As indicated in the certifications in Exhibit 32 of this report, our Chief Executive Officer and our Chief Financial Officer, with the assistance of other members of our management, have evaluated our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)). Based upon the evaluation of our disclosure controls and procedures required by Securities Exchange Act Rules 13a-15(b) or 15d-15(b), our Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective for the purpose of ensuring that material information required to be in this quarterly report is made known to them by others on a timely basis.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to the company’s management and board of directors regarding the preparation and fair presentation of published financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Changes in Internal Control Over Financial Reporting

We are involved in ongoing evaluations of internal controls. In anticipation of the filing of this Form 10-Q, our Chief Executive Officer and Chief Financial Officer, with the assistance of other members of our management, reviewed our internal controls and have determined, based on such review, that there have been no changes in internal control over financial reporting during the quarter ended April 1, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. Other Information

Item 1.Legal Proceedings

None.

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and / or operating results. The information presented below updates and should be read in conjunction with the risk factors and information discussed in our 2005 Form 10-K.

Our success in marketing consumer products in the U.S. depends on a number of factors, and we cannot assure you that our efforts will be successful

We have not sold substantial volumes of consumer products in the U.S., but as a result of acquiring Compex, we will devote resources to market consumer products for health and fitness applications. The consumer market for electrical stimulation products is new and developing, and our success in this market will depend on a number of factors, including:

	•		Our ability to obtain clearance from the FDA and other regulatory authorities to market electrical stimulation products for all relevant consumer applications;

	•		Our ability to maintain distribution rights with, and to obtain adequate quantities of product from, the manufacturers of consumer products for which we serve as a distributor;

	•		Our ability to establish consumer demand with a marketing budget which is relatively low compared to the much larger companies with which we compete in the electrical stimulation consumer market;

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	•		Our ability to secure “shelf space” in the United States with significant retailers; and

	•		The effectiveness of our new products for their intended applications.

Item 2.Unregistered Sales Of Equity Securities And Use of Proceeds

None.

Item 3.Defaults Upon Senior Securities

None.

Item 4.Submission of Matters to a Vote of Security Holders

A special meeting of our stockholders was held on February 23, 2006. At the meeting, our stockholders acted on the following matters:

1. Issuance of shares of common stock, par value $0.001 per share, pursuant to the Agreement and Plan of Merger, dated as of November 11, 2005, by and among Encore, Encore-Snow Acquisition Corp., which is a wholly owned subsidiary of Encore, and Compex Technologies, Inc.


Voted For	Voted Against	Abstain

39,297,992	127,400	129,782

2. Amendment to Encore’s 1996 Incentive Stock Plan increasing the number of shares of common stock authorized for issuance under the plan.


Voted For	Voted Against	Abstain

32,943,938	6,591,407	19,829

Item 5.Other Information

None.

Item 6.Exhibits


a)	Exhibits.
		31.1	Certification (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Executive Officer.

		31.2	Certification (pursuant to Securities Exchange Act Rule 13a-14a) by Chief Financial Officer.

		32.1	Section 1350 – Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief Executive Officer.

		32.2	Section 1350 – Certification (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) by Chief Financial Officer.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


May 10, 2006 Date	By:	/s/ Kenneth W. Davidson Kenneth W. Davidson, Chairman of the Board and Chief Executive Officer
		(Principal Executive Officer)


May 10, 2006 Date	By:	/s/ William W. Burke William W. Burke, Executive Vice President and Chief Financial Officer
		(Principal Financial Officer and Principal Accounting Officer)

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Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	H.S. freshman Good

ReAble Therapeutics Inactive 10-Q2006 Q1 Quarterly report

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